installment sales and scin’s chapter 35 tools & techniques of estate planning copyright 2011,...

Installment Sales and SCIN’s Chapter 35Tools & Techniques of

Estate Planning

Copyright 2011, The National Underwriter Company 1

• The installment sale is a device for spreading out the taxable gain and thereby deferring the income tax on gain from the sale of property

– Key: At least one payment will be received by the seller after the taxable year in which the sale occurs

What Are Installment Sales & Self-Cancelling Installment Notes (SCIN)?


Estate Planning


• The self-canceling installment note or SCIN is a hybrid between an installment note and a private annuity

– The note contains a provision under which the balance of payments due at the date of death are automatically canceled

– The term of the SCIN must be less than the life expectancy of the seller, otherwise it will be taxed as a private annuity

– Typically the note interest rate will contain a premium for the self-canceling feature

What Are Installment Sales & SCINs?


Estate Planning


• When a taxpayer wants to sell property to another individual who may not have enough capital to purchase the property outright

• Where an individual in a high income tax bracket holds substantially appreciated real estate or non-marketable securities and wishes to spread all or a portion of the tax due on the sale of such property over the period of installments

When Is The Use Of An Installment Sale Appropriate?


Estate Planning


• The installment sale can begin and end when the parties agree, unlike the rigid schedule that must be followed for a private annuity

• This is an estate tax freeze device, shifting future appreciation to the purchaser

When Is The Use Of An Installment Sales Appropriate?


Estate Planning


• Where the seller desires to retain a payment stream that will not continue beyond his or her death

• The SCIN allows the buyer to depreciate assets based on the purchase price paid and to deduct the portion of payments attributable to interest expense

• Where the tax benefits attributable to excluding the unpaid principal from a taxable estate exceed the income tax cost that results from the buyer paying a premium for the cancellation at death feature

When Is The Use Of A SCIN Appropriate?


Estate Planning


• No minimum sale price is required

• Seller of property can defer as much or as little as desired under the installment sale, and the amount of the payment received in a year is irrelevant

• Payments can be set to fit the seller’s business or financial needs

Note: With a SCIN the term cannot extend beyond the seller’s life expectancy, if it does it will be taxed as a private annuity

What Are The Requirements?


Estate Planning


• No payment has to be made in the year of the sale

• At least one payment must be made in a taxable year after the year of the sale

• Installment sale treatment is automatic, unless the taxpayer elects not to have installment treatment apply

• A sale can be made on an installment basis even though the selling price is contingent

• Installment reporting is not available for sales of marketable securities

What Are The Requirements?


Estate Planning


• Property title passes immediately from seller to buyer• Seller does not receive a lump sum payment outright

Example:• Mrs. Murphy sold land that cost her $50,000 for $100,000,

resulting in a $50,000 gain all reportable in the year of sale

• If instead Mrs. Murphy agrees to receive $10,000 plus appropriate interest for 10 years, she will not have to report a $50,000 gain all in the year of the sale

• Ignoring interest, Mrs. Murphy’s ration of gross profit ($50,000) to contract price ($100,000) is 50%

• Mrs. Murphy will report 50% of each $10,000 payment she receives or $5,000 as capital gain

How Is It Done?


Estate Planning


• SCIN’s require a premium to reflect the possibility that the seller will die during the term of note

• The buyer may be allowed an interest deduction if the debt was not personal and properly allocable to:– Investment purposes

– Conduct of a trade or business

– Part of the computation of income or loss from a passive investment activity

– Estate or GST taxes in installments under IRC Sections 6166 or 6161

– A debt secured by a qualified residence at the time the interest is paid or accrued up to prescribed limits

How Is It Done?


Estate Planning


• If the agreement does not specify an interest charge or the amount is too low, the IRS will impute interest, unless the parties agreed to a safe harbor rate of return on the unpaid balance

How Is It Done?


Estate Planning


• Rules of thumb for planning the interest rates that should be built into an installment sale:– There will be no imputed interest problem unless the

installment sale contract• Does not state any interest on the unpaid balance, or• The specified interest rate is less than the “applicable federal rate”

AFR• For intra family land sales the AFR is applied to amounts over

$500,000

– If the selling price is under $3,653,600 (2010) indexed, interest will be imputed at the lower of• 9% compounded semiannually, or the AFR rate

How Is It Done?


Estate Planning


Taxation Computation


Estate Planning


• Depreciation recapture and any investment tax credit recapture is reportable in full in the year of the sale, even if no proceeds are received in that year

• Installment treatment is generally not allowed for sales of depreciable property to a controlled entity or sales of marketable securities

Tax Implications Of An Installment Sale


Estate Planning


• The installment sale will remove the property from the seller’s estate, but the PV of any installments due at the seller’s death must be included

– Remember that the future appreciation of the sale property is removed from the seller’s estate without any gift tax consequences, and

– After receiving payments, the seller using annual exclusion gifting could gift back all or part of the proceeds further reducing potential estate taxes



Estate Planning


• Which interest rate to use when?– Tax Courts are split on whether to use prevailing market

rates, AFR, or special rates on sales of farmland– Adoption of AFR rates should eliminate the gift tax problem,

but it is unclear in the case where the AFR rates are lower than prevailing market rates

• If seller dies, remaining payments are reported as IRD, with no step-up in basis at death

• Under an installment sale, buyer’s new income tax basis is its FMV at date of the sale (purchase price)



Estate Planning


• Advantages of step-up in basis upon sale– A lower bracket family member purchasing the property can

sell it and probably pay much less tax than the seller would otherwise have to pay

– Proceeds can be reinvested in more liquid and higher yielding assets

• Generally interest paid by the purchaser on the unpaid balance will be deductible in full only if it is allocable to investment or business purposes



Estate Planning


• Second Disposition Rule– Certain resales (secondary dispositions) by a related party

purchaser trigger recognition of gain by the initial seller– Original seller’s gain will be accelerated if a trustee or other

related purchaser resells the asset within 2 years of the installment sale

– Where a second disposition results in recognition of gain to the first seller, subsequent payments received by the first seller will be tax-free until they have equaled the amount realized as a result of the second disposition

– This rule does not apply where the second disposition results from death of either party or involuntary conversion

Special Rules for Disposition of Property Between Related Parties


Estate Planning


• Rule for Cancellation of Debt– If an installment sale between related parties is canceled or

payment is forgiven

– Seller must recognize gain to the extent FMV on the date of cancellation exceeds the seller’s basis in the obligation



Estate Planning


• Special Depreciable Property Sale Rule– Applies only to related entities such as a corporation and an

individual that owns more than 50% of its outstanding stock– Sale of depreciable property between related entities may

not be reported on the installment method– Depreciation recapture must be reported by the seller in the

year of the sale up to the amount of the seller’s gain, and can be added to the seller’s basis



Estate Planning


• All of the tax rules that apply to the installment sale apply to the SCIN, along with some additional factors:– Upon death, gain will be fully taxable to the decedent’s estate

as IRD, not as income on the decedent’s final income tax return, where the sale was between decedent and his children

– For gift tax purposes, the actual value of the SCIN received by the seller is not equal to its face value because of the risk of seller’s death, otherwise the transaction would be treated as a bargain sale

– Since the balance of the SCIN is canceled at the seller’s death, there is nothing to include in seller’s estate for estate tax purposes

Tax Implications Of A SCIN


Estate Planning


• If a taxpayer has unrelated losses, he or she might wish to offset those losses with the gain from the installment sale

• If taxpayer has unusually low income or high deductions for the year– He or she would elect to report the full gain in the year of

the sale, even though the sale was on an installment basis to afford the buyer time to raise capital to make the payments

When Does It Make Sense To Forgo Installment Method Of Reporting?


Estate Planning


• Where an individual transfers property to someone else in return for installment payments:

– Seller will often purchase insurance on the life of the purchaser to protect against potential cessation of payments at the death of the purchaser

– The agreed upon amount of payments made by the purchaser of the property could be increased to provide enough cash to make premium payments

Use Of Life Insurance


Estate Planning


• Spouse or adult children of purchaser, or a trustee of an irrevocable trust for their benefit, will purchase a policy to:

– Ensure liquid funds to pay taxes and other death expenses on the purchaser’s increased estate value from the purchase of the installment sale property

– Provide liquid funds to continue to pay installment payments

Use Of Life Insurance


Estate Planning


• Both spouses should join in any conveyances of real property, otherwise the non transferor spouse may be able to void the sale for a specified period

• If undivided interests are sold at a discount, the amount of capital gains will be less, thereby creating estate tax savings and lower installment payments

• Possibly consider a separate sale of each spouse’s interest, where one spouse recognizes all the gain immediately and the other uses the installment method– Result: Reduce capital gains tax while effectively allowing a

greater amount of sale price to be received in the year of sale

Issues In Community Property States

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